Does Brexit Encourage Grexit, Emerging Market Fallout?

By

Dimitra DeFotis

June 14, 2016 12:13 p.m. ET

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While the probability of the UK staying in the EU remains greater than odds of leaving, there are three worries: will there be copycat referenda, where are bond yields headed and how will the vote affect the Fed's next decision on interest rates.

Meanwhile the Greek central bank wants creditors to rework the latest bailout because budget surplus target of 3.5 percent of GDP because the leftist government's agreed-to target is "unrealistic and socially unattainable." The central bank governor suggests a target of 2 percent of national output, CNBC reports. Greek equities have sustained the heaviest losses this week among exchange-traded funds in developing economies, with the Global X MSCI Greece ETF (GREK) down nearly 7% so far this week. The iShares MSCI South Africa ETF (EZA) is close behind, with a loss of 4.7% this week after it reported a wider current account deficit. The best emerging market performer this week is the illiquid and often static iShares MSCI Saudi Arabia Capped ETF (KSA), up 2.2%, followed by the Global X Pakistan ETF (PAK), up 1.7%. The new Saudi prince is in DC this week, and Pakistan anxiously awaits MSCI's decision on placing the country in the EM basket. The iShares MSCI Emerging Makets ETF (EEM) is down 2.4% this week.

"The Eurozone has over the last several years displayed a remarkable inability to move beyond immediate crisis fighting, at best resorting to incremental institutional build-out and heavy reliance on the policies pursued by Mario Draghi’s ECB. There has so far been only one trigger able to motivate more decisive action: immediate market pressure directly threatening individual members of the currency union. ... In previous days, anti-EU referendum outcomes were at times answered by a repetition of the respective vote – leading to even further integration. But as Brexit would take euroscepticism to the next level, senior (and pro-European) decision-makers such as German Finance Minister Wolfgang Schaeuble and European Council President Donald Tusk have made it very clear: more Europe cannot be the political answer to a resounding public No ... once the UK has decided to leave, the incentive for further compromise decreases significantly. Specifically, the Europeans will feel unable to give in on the four freedoms (including free movement of labor) as a precondition for single market access. The result would be potentially prolonged trade-talks, marred by uncertainty.

Overall, however, a potential Brexit would hardly change the main risk already long associated with the strength of populists across Europe: the continued rejection of any significant transfer of sovereignty to Brussels."

Capital Economics notes that because more recent opinion polls suggest that the UK will vote June 23 to exit the European Union, the yields on high-grade government bonds were falling again Tuesday -- and the German bund yield dipped below zero for the first time ever.

But Capital Economics analysts think high-grade bonds should "end the year higher than they are now, especially in the case of 10-year U.S. Treasuries." They think that Brexit may delay U.S. monetary policy, but that ultimately "irrespective of the outcome of next Thursday’s vote in the UK, we think that the FOMC will raise the federal funds rate in 2017 by far more than investors are currently anticipating in order to contain inflation."

So what might be on the Fed's radar this week when it comes to other global risks? Capital Economics' John Ashbourne notes that "South Africa’s current account deficit widened from 4.6% of GDP in the fourth quarter of 2015 to 5% of GDP in the first quarter. Meanwhile, Nigeria’s statistics bureau reported that inflation jumped from 13.7% year over year in April to 15.6% in May, a much greater acceleration than analysts expected, according to Bloomberg.

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